Curious Cat Investing Dictionary: Moral Hazard

Moral Hazard - a cirsumstance where behavior to contain risk is lessoned due to a person or organization being relieved of the consequences of risk. For example, with automobile insurance a person may be less vigilant that one without as one realizes that the risk of loss will be largely borne by the insurance company.

Public policy can encourage risky behavior by creating moral hazards. For example, the USA federal government providing homeowners insurance to millionaires on beachfront mansions when insurance companies refuse to take on such risk. The governmnet thus allows expensive homes to be built in risky areas with the assurance the taxpayers will foot the bill in the event of the likely damage to property.

Another example is when the government bails out large companies that took on risks - say with risky loans (international loans, junk bonds, sub-prime loans...). Each time the government chooses to support those that suffer losses it can create a moral hazzard that encourages companies to take on risks with the believe tht the government will provide a bail out if there is a large loss.